Following up on the previous post about CFD trading, I ended up losing all the deposits due to no risk management plan in place.
As a retrospection, I would like to reflect on what I learned and how to improve my position in the future trades.
Due to the massive fluctuation caused by the Coronavirus, my positions on CFD breached the 20% stop loss. Therefore the system sold my position and I lost my capital. This is mainly due to me not having a good risk management.
Is is a good period to jump back in using CFD? Probably not, due to recent events, my salary dropped 25%. Therefore I will need to temporarily suspend more risky investments for a short while.
The down side of CFD
As you might have guess, the major flaw of CFD is when the market goes against you big time. For my case, the stock I bought was AIZ, and it went down at least 40-50% in the last 4 weeks, making my position go bust. at 20% drop. I bought it when it already went down 20%, and from there it dropped another 30% and push the share price down to $0.8.
The problem is that we cannot control the market, therefore this is the risk that CFD traders have to bear. Let us make some calculations on how long we have to go to recoup our cost before we just don’t care about whether our position is foreclosed or not.
As calculated above, we need at least 5.5 years to recoup the principle, and anything after that is pure profit. We don’t need to care whether the principle is lost or not. This is assuming that we do not get margin called during that 5.5 years.
To summarize, the risks are significant when deciding to leverage to buy shares and to get good return are as follows:
- Market can be fluctuated more than what we are allocated for.
- Companies have to pay dividend continuously during the period we are involved in.
- Overnight fundings have to be prepared before the dividend starts rolling in (normally we need to prepare a year of interest).
How to mitigate risks?
The above risks are only what I can think of. There must other risks that I have not been able to forecast.
However, let’s take a look at how can we reduce our exposure to these risks, or how to have a risk management plan.
This may be hard to mitigate, since it is completely out of our control. However, there are some points that can help.
There are multiple types of fluctuation. Company-specific fluctuate can be neglected by choosing blue chip companies. They are more resistant to market changes and therefore the chance of them dropping below our stop loss (20%) is small.
Industry-specific fluctuate is harder to forecast the risk. Something could happen that disrupts the whole industry. Therefore a criteria when choosing which company to buy can include only buying companies that participates in old industries, such as banking, supermarkets, real estates, etc. These industries have proven track records and can be a bit more sturdy.
Worldwide fluctuation, or a global crisis, affects everyone. This is basically a dead sentence to people who are already participated in CFD trading. Market is absolutely impossible to predict, and the change deltas are unrealistic. To respond to this risk, the only thing that I can think of is not using a traditional CFD way to leverage in share investing, but rather using a different source to leverage, e.g. property equity.
Companies pay dividend continuously
The risk of our chosen company not paying dividend, or reducing dividend payment is real. However, we can partly mitigate this risk by choosing companies that have a long track record of paying dividend, as well as increasing dividend payment annually. We can also look at their financial reports and see if their dividend is sustainable.
This is probably the only thing that we can control. Basically we need to keep an amount of cash in the trading account to pay for the overnight funding charges. This is completely in our control so there is no excuse not to have enough funding. If we cannot pay the overnight funding, the platform might sell our position to cover the cost.
CFD trading is considered a high risk instrument. We need to be aware of foreseeable risks and find ways to mitigate them. In other words, we need to have a risk management plan in place.
My strategy going forward is to leverage into property and buy some dividend shares that can cover the interest rate from the mortgage.
By Tuan Nguyen